Vanguard STAR Fund tax distributions

The Vanguard STAR Fund is a questionable candidate for placement in taxable accounts. The fund is a balanced fund of funds, consisting of eleven Vanguard active stock and bond funds. [notes 1]. The fund maintains an approximate 60% equity/40% bond strategic asset allocation. The table below summarizes the fund's relation to a number of tax factors.

Distributions

The Vanguard STAR Fund has a fiscal year ending in October, so its reported distributions for a year reflect the prior year's December distribution of dividends and capital gains.

The following tables provide long term data on the Star fund's history of both dividend and capital gains distributions. As fund of funds, the fund's taxable distributions come from two sources:

Income and gains distributions received from the underlying funds.

The sales which the Star fund makes when rebalancing the fund.

We can see that the fund distributed considerable levels of capital gains during the early years of its existence, a period which coincided with the late years of a long bull market. The fund's capital gains distribution follows a common pattern for active fund management. When the fund, and the fund's underlying fund portfolios realize losses in bear markets, the resulting tax loss carryforwards result in very low tax distributions going forward until the carryforwards are depleted, after which taxable gains realization is renewed (see the second tab on spreadsheet Table 5 for loss carryforward data on the fund). The fund provides an approximate 35% qualified dividend distribution. The fund holds negligible treasury bond allocations, so the state income tax exemption that is a feature of treasury interest is not a tax factor for the fund. As of 2010, the Regulated Investment Company Modernization Act of 2010 [1] allows funds of funds to pass on the foreign tax credit from the individual funds to their shareholders.

Tax rates

Mutual fund distributions will be taxed according to the tax laws governing the investment over the holding period of the investment, which are subject to change. The actual tax imposed will depend upon each individual's tax rate and the timing of purchases and sales. The federal tax rates applicable to mutual fund distributions and investor sales of securities for the period 2013 onward are outlined below. Keep in mind that investment income may also be subject to state and local taxation.

Short-term capital gains distributions are made from realized gains on securities held for one year or less. Short-term gains are taxed at ordinary income tax rates up to 39.6%. Mutual fund short-term gain distributions are included in a fund's ordinary dividend distribution; therefore, capital losses may not be subtracted from these distributions when computing taxes.

Long-term capital gains distributions are made from realized gains on securities held for more than one year. Long-term gains are taxed at 0% for taxpayers in the 10% and 15% tax brackets, at 15% for taxpayers in the 25%, 28%, 33%, and 35% tax brackets, and at 20% in the 39,6% tax bracket. They are reported on tax Schedule D along with any other capital gains, and can be reduced by capital losses.

Qualified dividends are the ordinary dividends [notes 4] that are subject to the same tax rate that applies to long-term capital gains. They should be shown in box 1b of the Form 1099-DIV you receive.

When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both. If you offset capital gains that would have otherwise not been taxed at all (because your capital gains tax rate is 0%) then this part of the tax loss harvest may be an outright loss.

The Affordable Care Act imposes a Medicare surcharge of 3.8% on all net investment income (NII) once the taxpayer's adjusted gross income exceeds $200,000 (single) or $250,000 (married); while this tax is not part of the income tax, it has the same effect on investors as a higher tax rate. The NII tax begins to apply to individuals falling in the 33% tax bracket. Thus the top effective marginal tax rate is 23.8% on qualified dividends and long-term gains, 43.4% on ordinary investment income.

In addition, there is a 3.8% Medicare tax rate on investment income in excess of an adjusted gross income of $200,000 ($250,000 for married filing jointly), and 0.9% on salary and self-employment income in excess of this level. See: ACA net investment income tax

Tax analysis

The following table presents the federal tax cost on the fund's historical distributions (see second tab, table 4.) under the tax regime beginning in 2013 (with qualifying dividends and long term capital gains taxed at 0%, 15%, or 20% depending on tax bracket; and an ACA Net Investment Income tax imposed on higher tax brackets).

Keep in mind the distributions can also be subject to state and local taxation, with marginal rates ranging from 0% to 12% (an average 5% state tax rate will add an approximate 0.21% to the annual tax cost of holding the fund.) The fund's dividend and capital gains distributions for the 2004-2013 period are considerably lower than the distributions from the 1994-2003 period ( 3.38% dividend; 0.60% short term gain; 3.44% long term gain).

As an actively managed fund, one can expect that capital gains realization will persist going forward. The distributions will be lower after the realization of losses and the accumulation of loss carryforwards; distributions will be higher after any carryforwards are depleted (see the second tab of spreadsheet Table 5 for loss carryforward data).

The table does not include the capital gains cost associated with selling the fund at a gain. [notes 5]

Table 4.

(View Google Spreadsheet in browser, then File --> Download as to download the file.)

A portion of your ordinary dividend may be nonqualified because it can include items like these:

Taxable interest. When a mutual fund receives taxable interest, the income gets paid out as a dividend. It's a dividend when it goes out of the mutual fund, but it wasn't a dividend when it came into the mutual fund, so it can't be a qualified dividend.

Nonqualified dividends. Your mutual fund may receive dividends that are nonqualified. For example, the mutual fund may sell shares just 35 days after buying them, but after receiving a dividend. The mutual fund has to hold the shares at least 61 days to have a qualified dividend. Any amount the mutual fund receives as a nonqualified dividend gets paid to you as a nonqualified dividend.

Short-term capital gain. When a mutual fund has a short-term capital gain, it pays this amount to the mutual fund shareholders as an ordinary dividend.

Holding mutual fund shares less than 61 days. You should also be aware that any dividend you receive on mutual fund shares held less than 61 days is a nonqualified dividend, even if the mutual fund reports that amount to you as a qualified dividend. You don't have to buy the shares 61 days before the dividend is paid, but the total amount of time you hold the shares (including time before and after the dividend) has to be at least 61 days.

Almost all of the dividends distributed by Equity REITS come in the form of non-qualified dividends. Non-qualified dividends are taxed at marginal income tax rates.

↑ This table indicates the additional cost for the capital-gains tax when you sell, assuming that you pay taxes on the distribution and reinvest the after-tax portion of the distribution; since it is a one-time cost, the effect is annualized. For example, if you hold an investment for 30 years and lose 10% to taxes when you sell, that is equivalent to losing 0.35% every year. Thus, if you sell the fund, your cost will be the sum of the Table 4 and Table 6 costs. However, you would not pay the Table 6 cost on any stock which you either leave to your heirs or donate to charity, and thus may not pay that cost on your full investment. In particular, you might estimate your total tax cost by using the low-return line in Table 6; if stock returns are high, you will have a large taxable account and will reduce the tax cost by taking longer to deplete it or by not spending it all during your lifetime.
Taxes are computed at a tax rate of 15% on long-term gains (except in the "rate rises to 20% column", which applies if that tax reduction is allowed to expire), and on qualified dividends (except in the "no QDI" column, which applies if the tax reduction on qualified dividends expires and the rate is 35%). Although not tabulated, keep in mind that investors in the lower tax brackets (15% or lower) pay lower federal tax rates on investment income for the period 2003 - 2012, and reap higher after-tax returns, outside of tax-exempt municipal bonds, in all asset classes.